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Risk Theory: Professor Peter Cramton Economics 300

1) Expected value is not always the best criterion for choosing between lotteries as it does not account for risk preferences. 2) Individuals maximize expected utility rather than expected value, where the utility of monetary outcomes incorporates risk attitudes. 3) Risk aversion is characterized by a concave utility function, where the marginal utility of wealth is decreasing.

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Henmark Arisga Abejuela
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73 views

Risk Theory: Professor Peter Cramton Economics 300

1) Expected value is not always the best criterion for choosing between lotteries as it does not account for risk preferences. 2) Individuals maximize expected utility rather than expected value, where the utility of monetary outcomes incorporates risk attitudes. 3) Risk aversion is characterized by a concave utility function, where the marginal utility of wealth is decreasing.

Uploaded by

Henmark Arisga Abejuela
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PDF, TXT or read online on Scribd
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Risk Theory

Professor Peter Cramton


Economics 300
Is expected value a good criterion to decide between
lotteries?
• One criterion to choose between two lotteries is to choose the one
with a higher expected value

• Does this criterion provide reasonable predictions? Let’s examine


a case…
– Lottery A: Get $3125 for sure (i.e. expected value= $3125)
– Lottery B: win $4000 with probability 0.75,
– and win $500 with probability 0.25
– (i.e. expected value also $3125)
• Which do you prefer?
Is expected value a good criterion to decide between
lotteries?

• Probably most people will choose Lottery A because


they dislike risk (risk averse)
• However, according to the expected value criterion,
both lotteries are equivalent. Expected value is not a
good criterion for people who dislike risk
• If someone is indifferent between A and B it is because
risk is not important for him (risk neutral)
Expected utility: The standard criterion to choose
among lotteries
• Individuals do not care directly about the monetary values
of the prizes
– they care about the utility that the money provides
• U(x) denotes the utility function for money
• We will always assume that individuals prefer more money
than less money, so:

U '( xi )  0
Expected utility: The standard criterion to choose
among lotteries
• The expected utility is computed in a similar way to the expected
value
• However, one does not average prizes (money) but the utility
derived from the prizes
• The formula of expected utility is:

n
EU   pU
i ( xi )  p1U ( x1 )  p2U ( x2 )  ...  pnU ( xn )
i 1

• The individual will choose the lottery with the highest


expected utility
• Utility is invariant to linear transformation
V(x) = a + bU(x) for b > 0 is an equivalent utility function
Classification

U "( X )  0, strictly concave U(X)  Risk averse


U "( X )  0, linear U(X)  Risk neutral
U "( X )  0, strictly convex U(X)  Risk lover
Examples of commonly used Utility functions for risk
averse individuals

U ( x)  ln( x)
U ( x)  x
U ( x)  x a
where 0  a  1
 ax
U ( x)  1  e where a  0
$3000 is worth 65 units of
Example: Alex is considering a job, utility to Alex, and $9000 is
which is based on commission & pays worth 95 units of utility.
$3000 with 50% probability & $9000
with 50% probability. The utility of the job’s
earnings is the average of
65 & 95, or 80 units of
Utility utility.
95
We can see from the TU
85
80
curve that a job paying
$6000 with certainty would
65 be worth more to Alex (85
units of utility).
A job that paid $5000 with
certainty would be worth
the same level of utility to
3 5 6 9 Wealth
CE Alex as the risky job.
(thousands of dollars)
Measuring Risk Aversion

• The most commonly used risk aversion measure


was developed by Pratt
U "( X )
r( X )  
U '( X )

• For risk averse individuals, U′′(X) < 0


• r(X) will be positive for risk averse individuals
• r(X) = coefficient of absolute risk aversion
• r(X) is same for any equivalent U (i.e., a+bU)
Risk Aversion

• If utility is logarithmic in consumption


U(X) = ln (X )
where X > 0
• Pratt’s risk aversion measure is

U "( X )  X 2 1
r( X )     1 
U '( X ) X X

• Risk aversion decreases as wealth increases


ln(x) becomes “more linear”
1.5

1.0

0.5

2 3 4 5
Risk Aversion

• If utility is exponential
U(X) = -e-aX = -exp (-aX)
where a is a positive constant
• Pratt’s risk aversion measure is
2  aX
U "( X ) a e
r( X )     aX
a
U '( X ) ae

• Risk aversion is constant as wealth increases


CARA = constant absolute risk aversion
1.0
2 x
1 e
0.8

x
0.6 1 e
0.4

0.2

1 2 3 4
Willingness to Pay for Insurance

• Consider a person with a current wealth of


$100,000 who faces a 25% chance of losing
his automobile worth $20,000
• Suppose also that the utility function is
U(X) = ln (x)
Willingness to Pay for Insurance

• The person’s expected utility will be


E(U) = 0.75U(100,000) + 0.25U(80,000)
E(U) = 0.75 ln(100,000) + 0.25 ln(80,000)
E(U) = 11.45714
Willingness to Pay for Insurance

• The individual will be willing to pay more than $5,000 to


avoid the gamble. How much will he pay?
E(U) = U(100,000 - y) = ln(100,000 - y) = 11.45714
100,000 - y = e11.45714
y= 5,426
• The maximum premium he is willing to pay is $5,426
$426 more than “actuarially fair” insurance of $5,000
Summary
• Expected value is an adequate criterion to choose
among lotteries if the individual is risk neutral
• However, it is not adequate if the individual dislikes risk
(risk averse)
• If someone prefers to receive $B rather than playing a
lottery in which expected value is $B then we say that
the individual is risk averse
• If U(x) is the utility function then we always assume that
U’(x)>0
• If an individual is risk averse then U’’(x)<0, that is, the
marginal utility is decreasing with money (U’(x) is
decreasing).
• If an individual is risk averse then his utility function,
U(x), is concave
• We have studied a standard measure of risk aversion
and insurance

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